© 2014 Lakshmikumaran & Sridharan, India. All rights
reserved.
The Tree of Knowledge Knowledge Initiatives at L&S are nurtured
by a constant stream of analysis and opinion pieces by our
consultants and their practice experiences. The ‘Tree of Knowledge’
is a part of our wisdom initiative gleaned from the best of the
organisation’s learning, shared through the year.
Tax issues surrounding human capital movement
Engineering, Procurement and Construction (EPC) contracts in
India
Doing business in India through Liaison Office
Transfer Pricing and location savings - An Indian perspective
Marketing Intangibles in India
Transfer Pricing and Contract Research Centres in India
3
7
12
17
21
27
32
Navigating Key Tax Issues in India The transition of India from an
insular economy in the early nineties to a global economy is indeed
remarkable. It has thus become crucial that the tax environment of
the country keeps pace with the global tax regime. Till recently,
the tax environment in India was viewed as a complex system with
multiplicity of taxes, burgeoning litigation and lack of certainty.
This image is now set to change with recent initiatives of Indian
Government promising certainty and Tax Administration issuing
clarificatory circulars on complex and recurring controversies.
This booklet contains essays on key income tax issues that surround
the business environment in India dealing with the concept and how
to cope-up with these issues.
Tax issues surrounding human
4 | Lakshmikumaran & Sridharan Attorneys
Permanent Establishment (‘PE’) Transfer pricing law of the home
country would generally warrant a cross charge of the salary to be
received by the entity seconding its employees. Tax scrutiny
triggers on payment of such cross charge by the Indian subsidiary.
On various occasions, Indian courts have held a permanent
establishment of a foreign enterprise to have resulted because of
presence of its employees in India. Presence of PE can result in
applicability of tax @40% on the income attributable to the PE, the
quantification of which is again a subjective exercise. Service PE:
In the context of Indian tax treaties containing Service PE clause,
the secondment of employees for assisting
1 TAx ISSuES SurrOundInG humAn cAPITAl mOvEmEnT
Globalisation has led Multinational Companies (MNCs) to increase
cross border secondment of technical, managerial and other
employees to their subsidiaries located in low cost jurisdictions
such as India. The rationale behind seconding such employees is
sometimes to help the subsidiaries avail the benefit of skill and
expertise of the seconded employees in respective fields and
sometimes to exercise control. Such secondments on one hand
facilitate efficient business functioning and may, at times,
trigger tax liability for overseas MNC’s as well as for Indian
subsidiary. The MNC’s therefore, need to be aware of such areas
[infra] and accordingly carefully structure such assignments. The
present write-up highlights tax issues that generally crop up
whenever any employee is seconded to India.
the Indian group entity have been held to constitute Service PE
especially where the employees have contractual right of claiming
remuneration from home country entity and also maintain lien on
their employment with that entity.1 The exception is where the
services rendered constitute ‘technical services’ (infra) which
itself may be taxable in India as source country both under its
domestic law and treaty.
direct payment of employment compensation by Indian entity
disentitles the employee from potential claim of ‘short stay
exemption’ with respect to Indian Income tax and hence, balancing
the employee personal taxation with the corporate tax exposure
becomes a sensitive issue.
Fixed Place PE: many Indian treaties do not contain Service PE
clause and in such cases the PE exposure can only arise if the stay
of employees is prolonged and other tests of a fixed place PE are
satisfied. With respect to tests of a Fixed Place PE (viz. disposal
Test, Functionality Test and Permanence Test) due care needs to be
deployed while structuring the arrangement as in some cases the
courts have held disposal test to have been met where employees of
foreign enterprise have unrestricted access to premises of
subsidiary2 while in other cases the court found as a matter of
fact that employees of foreign entity did not have a right of
disposal but were merely permitted to be present at discretion of
Indian entity3.
Fees for technical services (FTS) Indian domestic law provides for
source based taxation on consideration for services which are in
the nature of managerial, technical or consultancy. Some of the
Indian treaties also replicate this provision. It is pertinent to
note that FTS is taxable in India on gross basis at the rate of
25%4 or at the rate provided in relevant double Tax conventions
(‘dTc’)5, whichever is lower. Such services are excluded from the
purview of Service PE. Some treaties, however, provide for a narrow
definition of FTS and in such cases the consideration may not
attract tax either as PE profit or as FTS.
TAx ISSuES SuRROunDIng huMAn CAPITAL MOvEMEnT
1 Centrica India Offshore Pvt. Ltd., - WP (c ) no. 6807/2012 dated
25.04.2014; DIT (International Taxation) v. Morgan Stanley &
Co. Inc. - Appeal (civil) 2914 of 2007 dated 9th July, 2007. 2
Motorola Inc. v. Dy. CIT - [2005] 147 Taxman 181 (AAr); Western
Union Financial Services Inc. v. Asstt. DIT - [2007] 104 ITd 34
(ITAT delhi). 3 Rolls Royce Plc. v. Dy. DIT - [2008] 19 SOT 42
(ITAT delhi) affirmed by delhi high court [2011] 339 ITr 147;
Seagate Singapore International Headquarters Pvt. Ltd. - [2010] 322
ITr 650 (AAr). 4 Section 115A of the Income Tax Act, 1961. 5 0% to
25%.
6 | Lakshmikumaran & Sridharan Attorneys
Transfer Pricing Implications The Indian Transfer Pricing
regulations are largely at par with the international practices and
require every company transacting with related enterprise
(‘Associated Enterprises’ or ‘AEs’) situated in a foreign
jurisdiction to offer for tax so much of profits as would have been
earned if it were dealing with unrelated parties. If the Indian
entity bears the remuneration of seconded employees, then tax
authorities need to be satisfied that nature of services performed
by them is not in the nature of shareholder activities or
duplicative activities. While these expressions have not been used
in Indian domestic law the focal point is that payment by Indian
entity should be commensurate with the benefit it has received on
account of services rendered by seconded employees.
COnCLuSIOn
Multiple aspects need to be taken care of, ranging from personnel
tax, via PE exposure for foreign enterprise to TP implications on
Indian entity. MNC’s, therefore have to be vigilant in structuring
the transaction so that tax cost is optimised without exposing
itself to controversies.
Engineering, Procurement and
2
2. EnGInEErInG, PrOcurEmEnT And cOnSTrucTIOn (EPc) cOnTrAcTS In
IndIA
The economic growth that India witnessed in last two decades has
attracted Multinational Enterprises (‘MNEs’) to increase manifold
their business presence in India. Many MNEs have won projects
involving Engineering, Procurement and Construction (‘EPC’) to be
undertaken on turnkey basis. An EPC contract generally involves
supply of goods and services, both offshore and onshore. Such
contracts may, either be a composite contract i.e. without any
breakup of consideration towards goods and services, or on the
other hand provide split up of the consideration. The present write
up aims at highlighting income tax issues that generally arise in
relation to such projects.
India follows a blend of residence based and source based taxation.
The treaty framework restricts taxability of MNEs with respect to
profits from their unincorporated Indian ventures only to those
cases where a Permanent Establishment is created in India or where
the income is in the nature of ‘fees for technical services’.
navigating Key Tax Issues in India | 9
Existence of permanent establishment (‘PE’) Presence of PE can
attract tax on the income attributable to the PE at the rate of 40%
as against regular corporate tax rate of 30%.
Generally the mnEs maintain project office in India in order to
efficiently execute the EPc contract. Indian courts have in some
cases held a permanent establishment of a foreign enterprise to
have resulted because of the project office in India observing that
the activities of installation, etc., were routed through such
office.6
Generally time threshold of 6 months is required to invoke
Installation/Supervisory PE and time threshold for each project is
taken individually. unless properly structured, the tax authorities
may find that multiple projects are interconnected and apply an
aggregate approach for determining whether PE threshold is
met.
many Indian treaties have specific clauses for installation and
supervisory PE. depending on the treaty language and facts of a
particular case, mere performance of supervision without
undertaking installation, construction, etc., can in some cases
create a PE.
Some of the Indian treaties recognize furnishing of services
(beyond a specific threshold) also as a PE creating activity. The
tax authorities tend to invoke Service PE clause where they are not
able to justify existence of Installation/Supervisory PE. They
allege that the visit of technical personnel for rendering onshore
services in respect of the EPc contract gives rise to Service PE.
The exception is where the services rendered constitute ‘technical
services’ (infra) which itself may be taxable in India as source
country both under its domestic law and treaty.
EngInEERIng, PROCuREMEnT AnD COnSTRuCTIOn (EPC) COnTRACTS In
InDIA
6 Samsung Heavy Industries Co. Ltd. v. ADIT - ITA no. 5237/del/2010
(ITAT delhi).
10 | Lakshmikumaran & Sridharan Attorneys
Commencement of PE The point of time at which the PE is said to
have been set-up is also an aspect that requires due attention. In
certain cases, attempt has been made by the tax authorities to
justify that PE comes into existence from the time when first
activity was undertaken by the foreign enterprise even though at
that point of time the activity may only have been preparatory or
auxiliary in nature. maintenance of robust documentation
corroborating the real nature of activities is extremely essential
to mitigate such exposure.
Offshore supply
Supplies made offshore, conceptually should not give rise to tax
implication in India.7 The contracts at times indicate that the
supply is complete and title over goods pass only after
satisfaction of certain conditions in India. In such cases, tax
authorities have at times endeavoured to tax the offshore supply.
This happens especially when there is a composite price8 for the
contract. In exceptional cases tax authorities have observed that
consideration towards non-taxable offshore supplies is inflated so
as to reduce the tax impact on taxable onshore activities9. A
justification of price break-up (on the lines of a transfer pricing
study) is imperative in such cases.
Offshore services such as design, drawings, documentation etc.
constitute inextricable part of offshore supply and usually
entitled for similar treatment. A detailed examination of the facts
and documents in some cases has revealed that what is ostensibly a
payment for assignment of design is in law a payment in the nature
of fees for technical services and taxable under source rule.
7 Ishikawajima-harima Heavy Industries Ltd. reported at [2007] 288
ITr 408 (Supreme court); CIT v. Hyundai Heavy Industries Co.
Limited - [2007] 291 ITr 482 (Supreme court); DIT v. LG Cable Ltd.
- 237 cTr 438 (delhi high court); DIT v. Nokia Networks Oy - [2012]
253 cTr 417 (delhi high court); Joint Stock Company Foreign
Economic Associa- tion ‘Technopromexport’, In re, 322 ITr 40
(Authority for Advance rulings); Hyosung Corporation, In re, 314
ITr 343 (Authority for Advance rulings); DCIT v. Roxon Oy. - 291
ITr (T) 275 (ITAT mumbai); Toshiba Plant Systems & Services
Corp., Japan, In re, 332 ITr 456 (Authority for Advance
rulings).
8 Linde AG, In re, [2012] 349 ITr 172 (Authority for Advance
rulings); Alstom Transport SA - [2012] 349 ITr 292 (Authority for
Advance rulings); Roxar Maximum Reservoir Performance WLL, In re,
[2012] 349 ITr 189 (Authority for Advance rulings).
9 Ansaldo Energia SPA.
EngInEERIng, PROCuREMEnT AnD COnSTRuCTIOn (EPC) COnTRACTS In
InDIA
Offshore services - Fees for technical services (FTS)? Indian
domestic law provides for source based taxation on consideration
for services which are in the nature of managerial, technical or
consultancy. Some of the Indian treaties also contain similar
provision. It is pertinent to note that FTS is taxable in India on
gross basis at the rate of 25%10 or at the rate provided in
relevant double Tax conventions (‘dTc’)11, whichever is lower. Such
services are usually excluded from the purview of Service PE but
can be taxed as PE profits if the contract generating FTS is
effectively connected with the PE. Some treaties, however, provide
for a narrow definition of FTS and in such cases the consideration
may not attract tax either as PE profit or as FTS.
COnCLuSIOn
As EPC projects involve huge amount of investment, MNEs need to be
cautious in respect of the tax exposure and take necessary
safeguards to optimize the tax cost.Careful drafting of the
contracts, meticulous planning and diligent conformity of the
conduct with the contract are key factors for keeping taxmen at
bay.
10 Section 115A of the Income Tax Act, 1961. 11 0% to 25%.
Doing business in India through Liaison Office
3
3. dOInG buSInESS In IndIA ThrOuGh lIAISOn OFFIcE
The way Indian economy withstood global economic slowdown has made
India a very alluring destination for foreign investments. For
testing Indian waters, many Multinational Companies (‘MNCs’ or ‘HO’
or ‘Non-resident’) prefer opening a Liaison Office (‘LO’) in India.
LO can be set up in India only after obtaining permission from
Indian central bank i.e., Reserve Bank of India (‘RBI’). LO can
carry out only restricted activities viz.,
• Representing parent company/group companies in India;
• Promoting export/import from/to India;
• Promoting technical/financial collaborations between parent
company/group companies and companies in India
• Acting as a channel of communication between the MNC and the
potential customers in India
In a nutshell, LO is not permitted to undertake any business
activity in India and thus, cannot earn any income in India.
Further, expenses of LO are to be met fully through permitted
channels from HO outside India.
MNCs are liable to Income tax in India as per Income Tax Act, 1961
(‘the Act’) if interalia there exists a business connection with
India. The Double Taxation Avoidance Agreements (‘DTAA’) with other
Countries however supersede the Act and the Act applies only to the
extent it is more beneficial to the Non-resident. As per the DTAA,
business profits of a Non-resident can be taxed in India only if
the Non-resident carries on its business in India through a
permanent establishment (PE).
14 | Lakshmikumaran & Sridharan Attorneys
Functions of LO that were viewed as taxable presence in India
• Identifying new customers, pursuits and follow-ups with
customers, price negotiation and finalization, securing orders,
payments for material and post-sale support12;
• Conducting substantial activities such as designing of apparel
with material to the taste of the customers and after adequate
research, supervision of the manufacturing process etc.13;
• Payment of salaries and managing pay rolls of corporate audit
staff14;
• Vendor development, developing garment designs jointly with the
vendors and overseas clients, sample preparation/approval, price
negotiation, order tracking, production/process control, supply
chain management etc.15;
• Procuring purchase orders, identifying the buyers, negotiating
with the buyers, agreeing to the price and thereafter requesting
them to place a purchase order16;
12 [2012] 206 Taxman 7 (Karnataka high court). 13 Columbia
Sportswear Co. - [2011] 337 ITr 407 (Authority for Advance rulings
(AAr)). 14 General Electric International Operations Co. Inc. -
[2014] 44 taxmann.com 436 (ITAT delhi). 15 Linmark International
(Hong Kong) Ltd. - [2011] 57 dTr 340 (ITAT delhi). 16 Jebon
Corporation India - 2011-TII-15-hc-KAr-InTl
In recent past, Indian Revenue Authorities have found that some
MNCs carried on commercial operations in India under the guise of
an LO and sought tax on it as if it was a PE. There has been
extensive litigation surrounding the issue as to when does an LO
cross the boundaries and become a PE.
The present write-up is an outcome of an extensive analysis of
judicial precedents on the subject and seeks to summarise key
points emerging there-from.
navigating Key Tax Issues in India | 15
Functions viewed as not creating a taxable presence
• Holding seminars, directing trade enquiries received to HO,
advertising the technology used by the group17;
• Communicating the decision of the HO to the customers in
India18;
• Activity of downloading information from servers, printing and
forwarding to beneficiaries in India19;
• Enabling Indian manufactures to manufacture goods of particular
specification as required by HO20;
• Providing training, conducting refresher course for agents about
standards of service and security, accounting procedures,
telecommunication systems and configurations, merchandising
standards etc.21;
Filing of annual statement by MnC for their LO In addition to the
requirement of ascertaining the taxable presence, the Act requires
mncs to comply with reporting requirement for an lO in India. mncs
are required to file an annual statement with the jurisdictional
income-tax officer within 60 days from the end of the financial
year containing information about regulatory approval for setting
up the lO, its address, tax registration of hO, details of salary
to staff in lO, etc. There have been many cases of failure to make
due compliance regarding taxability of employees of lO including
non-compliance of tax withholding provisions in that regard. It is
therefore imperative to take stock of affairs and compliance with
respect to lO. The said annual statement is to be filed in
electronic form along with digital signature.
DOIng buSInESS In InDIA ThROugh LIAISOn OFFICE
17 K. T. Corpn. - [2009] 181 Taxman 94 (AAr). 18 Mitsui & Co.
Ltd. - [1991] 39 ITd 59 (ITAT delhi-Special bench). 19 UAE Exchange
Centre Ltd. - [2009] 313 ITr 94 (delhi high court). 20 Nike Inc. -
[2013] 217 Taxman 1 (Karnataka high court). 21 Western Union
Financial Services Inc. - [2007] 104 ITd 34 (ITAT delhi).
16 | Lakshmikumaran & Sridharan Attorneys
COnCLuSIOn
Ensuring proper tax and regulatory compliance in relation to the LO
is extremely important and requires meticulous planning with
careful execution. The extent to which an LO is duly compliant is
to be carefully analyzed in light of the activities carried out by
each LOs and judicial interpretations. MNC’s, therefore have to be
vigilant in structuring the format of LO so that it is not exposed
to tax liability or penalties by the regulator.
Doing business in India through Liaison Office (contd.)
Transfer Pricing and location savings - An
Indian perspective
4. TrAnSFEr PrIcInG And lOcATIOn SAvInGS - An IndIAn
PErSPEcTIvE
22 OEcd revised discussion draft on Transfer Pricing Aspects of
Intangibles, July 2013July 2010 23 Para 5.3.2.41 of united nation
Practical manual on Transfer Pricing for developing countries,
2013
Relocation of business from one country to another, where the labor
and other costs are comparatively cheaper, results in cost saving
to the Multi National Enterprise (‘MNE’) groups. The net cost so
saved is Location Savings (‘LS’) as explained by the Organization
for Economic Co-operation and Development (‘OECD’)22.The United
Nations further expands the scope of LS to include certain
advantages specific to a state, like huge customer base, advantage
of infrastructure, etc, and terms LS as Location Specific
Advantages (‘LSA’)23.
LSAs have encouraged MNEs operating in high cost jurisdictions like
USA and Europe to divert their capital to countries like India and
China. While a portion of the cost saved by the MNE group is
retained in the low cost state, significant sums are usually pulled
back by the holding companies. Indian tax authorities have recently
taken recourse to local Transfer Pricing Regulations to tax such
extracted profits.
navigating Key Tax Issues in India | 19
Transfer Pricing on LSA - International practice The OEcd and un
have acknowledged lSA as a premium enjoyed by low cost
jurisdictions. OEcd is of the view that where reliable local market
comparables are available and can be used to identify arm’s length
prices, specific comparability adjustments for location savings
should not be required24. The un, though vouching the practice, has
added that, the first entrant in the low cost jurisdiction should
be entitled to a premium25. The un refers to the premium as ‘Arm’s
length Surplus’.
uSA’s regulations and courts26 seem to have acknowledged the view
of un that location saving if any, would exist only till comparable
service providers emerge in the low cost market. Enough guidelines
are however not available on how to treat the lSA that accrued to a
first entrant. recent amendment to the German Foreign Tax Act has
created a rebuttable presumption that location saving must be
allocated between the parent and the subsidiary27. The Finnish
Administrative court28 has also acknowledged adjustment for lSA if
the very same functions earlier performed in Finland were moved to
a low cost jurisdiction. china, which also provides significant
cost saving to manufacturing groups, more specifically automobiles,
has put in place a specific rule to measure and allocate location
saving.29
Location Saving and India India extends a variety of cost saving to
mnEs operating in developed countries. Such lSAs include human
resource at discounted costs, huge customer base, easy physical
access to whole of Asia, etc.
India does not have a specific regulation to identify or allocate
lSA. In the country Practice chapter of un Practical manual, the
possibility of application of Profit Split method (PSm) has
been
TRAnSFER PRICIng AnD LOCATIOn SAvIngS - An InDIAn PERSPECTIvE
24 Para 9.149 of OEcd Transfer Pricing Guidelines for multi
national Enterprises and Tax Administrations, July 2010, further
elaborated in Para d.6.1 on revised discussion draft on Transfer
Pricing Aspects of Intangibles, July 2013. 25 Para 5.3.2.44 of
united nation Practical manual on Transfer Pricing for developing
countries, 2013. 26 Baush and Lomb Inc v Commissioner 27 Transfer
Pricing and Arm’s length Principle in International Tax law, Kluwer
law International bv, 2010. 28 KhO 2013:36 29 Paras 10.3.3.4 –
10.3.3.10 of united nations Practical manual on Transfer Pricing
for developing countries, 2013.
explored, as a means to allocate the location benefits derived by
mnEs30. In the context of Indian research &development centers
of mnEs, the central board of direct Taxes (cbdT) expressed a view
that an upward adjustment shall be made to the Transfer Price for
lSA31. This circular was however later withdrawn32 due to
significant protest from stakeholders.
Even in the absence of specific regulations and the Government
still ‘exploring’ an appropriate method, the revenue Authorities
(‘rA’) during audit have been making upward adjustment for lSA
derived by mnEs. courts in India have so far been adopting a
liberal approach towards it. The Income Tax Tribunal in the case of
GAP International 33 observed that lSA would generally be passed on
to end customer, and even if it is not, AlP determined based on
appropriate comparables will ensure that lSA is adequately
compensated. The delhi high court in Li and Fung India 34 rejected
the claim for adjustment for lSA in the absence of specific finding
on the existence and quantum of lSA.
What should be India’s revenue policy? India has been showcasing
its lSA to attract35 foreign investment into India. Eyeing
investment by mnEs, India has also extended investment linked tax
benefits to new investments in identified zones36 and in specified
sectors37, carefully balancing its limitations on account of
commitment under General Agreement on Trade and Tariff. As a result
of these measures, India is now amongst the top five investment
destinations. having invited mnEs to invest in India by showcasing
the lSAs it can offer, it would not be appropriate for India to
impose a tax on the lSA itself.
Secondly, lSA being enjoyed by India is no more unique. There is
significant competition within India, and as a result, there will
usually be enough comparables for AlP determination. In this
scenario, even as per the recommendations of un, no adjustment on
account of lSA is desirable.
Location Saving and India (contd.)
30 Para 10.4.7.3 united nations Practical manual on Transfer
Pricing for developing countries, 2013. 31 circular 2 of 2013 dated
26.03.2013 32 circular 5 of 2013 dated 29.06.2013 33 GAP
International Sourcing (India) (P.) Ltd. v ACIT - [2012] 149 TTJ
437 (delhi). 34 Li and Fung India (P.) Ltd. v CIT - [2014] 361 ITr
85 (delhi). 35
http://www.investindia.gov.in/InvestIndia_brochure_web.pdf 36
Income Tax, customs and Excise exemption provided for new
undertakings established in Free Trade Zones, Special Economic
Zones etc. 37 Income Tax, customs and Excise exemption provided for
investment in developing infrastructure, generation of power,
providing telecommunication services etc.
Marketing Intangibles in India
5. mArKETInG InTAnGIblES In IndIA
Assets like Trade Marks, Trade Names, Brand Names, Logos etc.,
individually indentified as Intangible Assets, when promoted in a
systematic manner to create a value in an identifiable geographical
area, are collectively referred to as ‘Marketing Intangibles’. This
phrase has got special attention in the field of Indian transfer
pricing in the recent past. Transfer pricing authorities have
started enquiring into the amount of expenses incurred by an Indian
subsidiary of an MNC on account of Advertisement, Marketing and
Promotion (AMP) of a brand vis-a-vis the benefit derived there-from
by the Indian subsidiary and other Associated Enterprises (AEs)
situated abroad.
The perception that the Indian subsidiaries use the brand- name of
the parent company for exploitation of the local market, over a
period of time, has shifted to the Indian subsidiary being used as
a vehicle to promote the foreign brand itself in India.
beginning 2008, the Indian revenue Authorities started focusing on
such arrangements. maruti udyog limited (‘maruti’) was to be the
first reported case. maruti, established in 1983, grew to be the
biggest carmaker in India. maruti entered into a technology usage
agreement with Suzuki motor corporation, Japan (‘Suzuki’) that also
provided for the use of the latter’s brand in India that was
hitherto unknown in India. The revenue Authorities argued that
maruti promoted the foreign brand “Suzuki” by including the logo of
Suzuki in maruti’s products and advertisements. Promotion of an
unknown brand in India was an international transaction by itself
requiring an arm’s length compensation, accordingly to the revenue
Authorities.
MARKETIng InTAngIbLES In InDIA
On a reference to the delhi high court38 against the order of the
revenue Authority, the high court made the following
observation:
“If the domestic entity which is an Associate Enterprise of the
foreign entity within the meaning of Section 92A of the Income Tax
Act is mandatorily required to use the foreign trademark and/or
logo on its products and/or their containers, packaging, etc.,
appropriate payment in this regard should be made by the foreign
entity to the domestic entity, on account of the benefit it derives
in the form of marketing intangibles, obtained by it from such
mandatory use of its trademark and/or logo.”
The delhi high court thus laid emphasis on the fact that an
obligation has been cast on the Indian entity to use the brand to
establish that a benefit has accrued to the foreign entity. The
issue was then remanded for quantification of the Arm’s length
Price (‘AlP’) for the transaction.
In a later decision, the Special bench of the delhi Tribunal in LG
Electronics India (P) Ltd. v. ACIT39 held that the activity of
using the brand owned by an mnc in advertisements in India would
per se be an international transaction.
Quantification of compensation The high court in Maruti Suzuki
(supra) observed that the AlP for such transactions would be the
excess of expenditure incurred by an AE over and above the expenses
incurred by an independent entity under similar circumstances,
generally referred to as bright line Test (“blT”). On an appeal,
the hon’ble Supreme court40 directed the revenue Authority not to
be influenced by the directions of the high court and to proceed
with the examination.
The Tribunal in LG Electronics (supra) has given much broader
guideline for estimating the quantum of AmP expenses that would be
regarded as being required for the business carried out in
India.
38 [2010] 328 ITr 210 (del). 39 [2013] 140 ITd 41 (del). 40 Maruti
Suzuki India Ltd. v. ACIT - [2011] 335 ITr 121 (Sc)
24 | Lakshmikumaran & Sridharan Attorneys
The guidelines cover the examination of the following:
a. Whether the goods sold by the Indian entity contain the brand of
AE alone or a joint logo of the AE and the Indian entity?
b. Whether the foreign brand is an established brand in India or a
new entrant?
c. Whether the Indian entity is paying any royalty to the AE and if
yes, is it at ALP?
d. Whether the Indian entity is a manufacturer or
distributer?
e. Whether the AE is compensating the Indian entity for brand
promotion in any form, like subsidy on the goods sold?
f. If such subsidy is granted, is it commensurate with the expenses
incurred for brand promotion?
g. Whether any new product has been launched during the subject
period or is it a continuation of business of same products?
h. How would the brand be dealt with after termination of agreement
with AE?
Scope of Marketing Expenses A company incurs various selling and
marketing expenses over and above what may be regarded as brand
development expenses. Any Transfer Pricing adjustment on account of
AmP expenses should ideally be restricted only to advertisement and
branding expenses and not to extend to expenses that do not promote
the brand of the foreign entity. In GlaxoSmithkline 41, Canon India
42 and many other rulings, it has been held that expenses on
account of Selling commission, cash discount, volume rebate, Trade
discount etc., shall not be considered for TP adjustment.
Quantification of compensation (contd.)
navigating Key Tax Issues in India | 25
however, in order to avail the full benefit of the above cited
rulings and to avoid litigation, Indian entities should follow
standardized accounting practices for sales related expenses and
also maintain adequate documentation distinguishing expenses that
promote the brand of the foreign entities and other promotion
expenses.
Other possible means to deal with the issue Indian Tax Authorities
and courts have so far stuck to method of benchmarking AmP expenses
of Indian taxpayer with comparable companies for determination of
AlP. however, there can be other plausible variations as followed
by revenue Authorities of other jurisdictions. A few such variants
are discussed below.
First, long-term exclusive agreement to exploit the Trade mark in
India can be imputed. This would give the subsidiary a right to use
the Trade mark for a period over and above the term specified in
the license agreement.
Second, in cases where the promotion activities are significantly
high and where the value of the brand is significantly derived from
India, the revenue Authority can treat the brand to be located in
India and bring to tax a part of the licence fee received
abroad.
Third, one can examine the AmP expenses for a block of five years
to determine whether the expenses are excessive. The blT approach
adopted so far in India is getting slowly refined. The revenue
Authorities are likely to revisit their stance in this regard. The
apex tax administration body, central board of direct Taxes (cbdT),
has recently become very active regarding issuing clarifications on
major tax disputes. cbdT is also likely to step forward and issue
guidelines for the clarity of the stakeholders.
MARKETIng InTAngIbLES In InDIA
26 | Lakshmikumaran & Sridharan Attorneys
COnCLuSIOn
Mere comparison of marketing expenses of an Indian entity with
another is too crude a method of determining ALP of AMP expenses.
Using such a method in arriving at the tax liability of the
taxpayer is unlikely to be accepted by the higher judicial forums.
The jurisprudence in this regard is still evolving in India. Indian
courts are expected to add new dimensions to the whole issue in the
years to come. It is, therefore, imperative to take a cautious
approach and take informed decisions after taking into account the
current practices in their entirety.
Marketing Intangibles in India (contd.)
Shareholder’s activity – India’s stand
6
6. ShArEhOldEr’S AcTIvITy – IndIA’S STAnd
Subsidiaries of Multi National Enterprises (‘MNEs’) generally avail
the services of their group companies for routine business
operation and management. When such intra group services are paid
for, questions often arise as to whether the services received are
essential for business operations of the subsidiary, or are the
services carried out by the MNE group with a view to secure their
investment in the subsidiary, the latter being generally referred
to as ‘share holder activity’. Income tax regulations of many
jurisdictions provide for tax deduction only for the first class of
services received.
OECD’s approach The 1979 Organization for Economic co-operation and
development (‘OEcd’) report suggested a ‘justification of benefit
test’ to identify shareholder activities. however, in 1995, the
OEcd revisited the position and observed that intra-group service
will be regarded as rendered when ‘the activity provides a
respective group member with economic or commercial value to
enhance its commercial position’ 43. The 1995 Guidelines modified
the definition of ‘shareholder activity’44 as the activities ‘that
a group member performs solely because of its ownership interest in
one or more other group members, i.e. in its capacity as
shareholder’. There was, thus, a noticeable deviation in the 1995
model from the 1979 model.
43 Para 7.6 of 1995 Guidelines 44 Para 7.9 of 1995 Guidelines
navigating Key Tax Issues in India | 29
The uS approach In 1977, the united States regulations45 clarified
that the expenses incurred on overseeing the activities of a
subsidiary shall be regarded as ‘stewardship activities’ and shall
be attributable to dividend received. uS courts have interpreted
these regulations to mean the activities that related to securing
investments in foreign subsidiaries. In columbian rope co’s case46,
the Tax court held that rendition of services to a ‘fully staffed’
subsidiary would be regarded as shareholder’s services and not a
service for the purpose of the subsidiary.
On the other hand, provision of services essential for the ‘day to
day’ operations of the subsidiary have been held to not to be in
the nature of shareholder’s activities in Eli Lilly and Co 47. In
relation to services that benefit both the parent and the
subsidiary, the Technical Advice memorandum48 issued by Internal
revenue Service of the uSA provides that an examination has to be
done as to which of the entities have derived ‘direct and proximate
benefit’ from the service49. The services would be regarded to have
benefited the entity which has obtained direct benefit than the
entity that has derived an indirect benefit50.
Thus, over the years, the courts in uSA adopted a broad standard
for identification of share holder activities. however, in 2009, a
narrower concept of ‘shareholder activity’ was introduced in the
regulations51, which its meaning to those activities which have
‘the sole effect of protecting the capital investment of the
service provider or to facilitate compliance with reporting or
legal or regulatory requirements for the MNC group 52’. Thus, both
OEcd and the uS moved to the ‘sole beneficiary’ test for
determination of shareholder activity.
45 § 861 regulations. 46 Columbian Rope Company v Commissioner -
[1964] 42 Tc 800. 47 Eli Lilly and Co v Commissioner - [1985] 84 Tc
996 48 TAm 8806002 49 Similar observation can be found in the
circular issued by Italian Tax Authorities. 50 Similar observations
are made by the new Zeeland revenue Authorities also. 51 §
1.482-9(l) 52 § 1.482-9(l)
ShAREhOLDER’S ACTIvITy – InDIA’S STAnD
European union’s Approach In Europe, Tax deduction of expenses is
governed only by the general law on deductibility and the Transfer
Pricing regulations cover the determination of quantum of expense
to be allowed53. however, revenue Authorities of a few States have
issued internal guidelines on deductibility of share holder costs.
German revenue Authorities seem to suggest that no charge may be
made for the administration, management, control, advisory or
similar functions insofar as they arise from shareholding
relationships or from other connections establishing a relationship
of the parties. The Austrian Administrative court54 held that
‘group charges and allocation fee’ paid to the holding company,
without any verifiable evidence would be considered as distribution
of hidden profits and not as allowable business expense. The
Spanish high Administrative court55 held that costs incurred to
adopt the requirement of parent were in relation to shareholder
activities. The dutch ministry of Finance has clarified that if the
group company is not able to independently, without a guarantee
from an AE, raise a loan, the guarantee will be provided in a
shareholder’s capacity.
India’s approach India does not have specific guidelines for
identification or treatment of consideration paid for shareholder
activity. A specific observation has however been made by India in
the un Practical manual on Transfer Pricing for developing
countries that share holder services will not be regarded as
services at all56. India has, however, agreed that identification
of shareholder services would need a great deal of analysis.
The issue of categorizing certain services as shareholder services
has been raised by the taxpayer57 as well as by the revenue
Authorities58 before juridical forums in India. however, the
judgments did not give a conclusive ruling. contrary views exist on
the question of whether issuance of corporate guarantee to a
subsidiary is a transaction entitled to a separate
consideration59.
53 Para 3.1.1 of Final report on Shareholder costs of the Eu Joint
Transfer Pricing Forum. 54 vwGh 14.12.2000, 95/15/0129 55
resolución del Tribunal Económico-Administrativo central of 25 July
2007. 56 Para 10.4.9.4 57 Ground no. 13 in Bharti Airtel Ltd v ACIT
- [2014] 161 TTJ 428 (del); Para 21 in Four Soft (P.) Ltd v. DCIT -
[2014] 44 taxmann.com 479 (hyderabad - Trib.) 58 Para 11 in
Invensys Systems Inc., In re [2009] 317 ITr 438 (AAr); Para 3.2 in
DCIT v Lear Automotive India (P.) Ltd - [2014] 41 taxmann.com 307
(delhi - Trib).
navigating Key Tax Issues in India | 31
To sum up, the activities performed by the parent company, which a
subsidiary would not have hired an unrelated company to perform,
would be regarded as shareholder services60. The responsibility of
establishing that the services paid for is not shareholder service
is on the Taxpayer. In the absence of proper documentation, the
revenue Authorities have been considering Arm’s length Price of any
payment to be ‘nil’, though the courts have held against such
determination61.
To defend a claim for deductibility of intra-group services, the
taxpayer as well as the service provider should maintain adequate
documentation. The documentation could illustratively be:
a. Detailed description of the service ideally captured in an
agreement
b. Resolution from the subsidiary for the need of such
services
c. Proposal and quote from the services provider for the
services
d. Details of persons who would render/have rendered such services,
their qualification, their roles and responsibility in the share
holder entity
e. Document capturing the fact of rendition of the service, e.g.
minutes of teleconference/videoconference, copies of presentations
received, e-mails, details of visits etc.
f. Control exercised by the taxpayer on the service provider which
renders such services
g. Satisfaction report from the subsidiary after completion of the
rendition of services.
This issue, though is in nascent stage in India, has been prevalent
in other jurisdiction since 1960s. It would only be appropriate for
the central board of direct Taxes to consider the precedence and
issue a circular to guide the taxpayers, revenue Authorities and
Appellate Authorities. Sans such circular, taxpayers should
formulate transparent policies for rendition of services and
maintain documentation on the basis of the practices of other
jurisdictions.
59 Everest Kanto Cylinder Ltd. v DCIT - ITA no 542/mum/2012 holding
that corporate Guarantee to a subsidiary would entail a
consideration and Bharati Airtel Ltd v ACIT - ITA no 5816/del/2012
holding otherwise. 60 Merck and Co v United States - [1991] 24 cl
ct 73. 61 CIT v. EKL Appliances Ltd. - [2012] 345 ITr 241
(del)
ShAREhOLDER’S ACTIvITy – InDIA’S STAnD
Transfer Pricing and Contract Research Centres in India
7
7. TrAnSFEr PrIcInG And cOnTrAcT rESEArch cEnTrES In IndIA
Globalization coupled with high skill at low cost feature of India
has prompted many Multinational Enterprises (‘MNEs’) to outsource
their business segments to India. With the passage of time,
dimensions of outsourcing have extended to niche areas like
Research and Development (‘R&D’) as well. MNEs in developed
countries that are shifting their R&D functions to India,
wholly or partially, need to be cautious about their taxation,
especially Transfer Pricing (TP).
Conceptual background from a Permanent Establishment perspective
Indian Supreme court in 195362 had held that a systematic and
habitual activity having special skill and competency in executing
the task assigned is sufficient to create a taxing nexus, referred
to as ‘business connection’. The term ‘business connection’, though
much broader than the definition of a PE, falls on the same concept
of a nexus between the business of the foreign enterprise and
activities carried out within a taxing jurisdiction.
OEcd commentary on model Tax convention has maintained a position,
since 1963, that research activities are preliminary and auxiliary
to the actual realisation of profits by an enterprise and that no
profit can be attributed to such research activity. Similar is the
position of maintaining a place for mere purchase function.
Skaar63 also supports OEcd view de lege lata however comments that
the same is not persuasive de lege ferenda.
62 Anglo French Textile Co. Ltd. V. CIT - 23 ITr 101 (Sc) (4 Judge
bench). 63 Arvid Skaar, Permanent Establishment, Erosion of Tax
Treaty Principle
34 | Lakshmikumaran & Sridharan Attorneys
It appears that in harmony with the view of Supreme court, Indian
tax administration has given its observations on OEcd commentary
that it does not agree with the interpretation given [regarding
research activities and] it would not include scientific research
in the list of examples of activities indicative of preparatory or
auxiliary nature.
Transfusion of the concept into Transfer Pricing (TP) regulations
In the Practical manual on TP for developing countries released by
united nations, a separate chapter is devoted to country specific
practices. Indian tax administration expressed therein that r&d
efforts in India require a proper compensation, which could be by
way of imputing royalties for use of know-how developed in India.
The practice of mnEs providing a low cost plus mark up on the
ground that they control all the risk and their Associate
Enterprise (AE) operating in India are risk free or limited risk
bearing entities was also condemned in that chapter.
On similar lines bangalore bench of the Income-tax Appellate
Tribunal (‘ITAT’), in the case of GE India Technology Centre 64
held that the ability of the foreign AE to exercise control over
risks remotely from the place where the core r&d functions
(carried on by Indian taxpayer) are not located is very
limited.
The central board of direct Taxes65 (cbdT issued two circulars in
the year 2013 viz. circular 2/2013 and circular 3/2013. circular
3/2013 laid down five conditions to be cumulatively satisfied so as
to demonstrate that the Indian entity providing r&d services is
a risks mitigated entity. circular 2/2013 stated that Profit Split
method would be the best method for determining Arm’s length Price
(AlP) of remuneration of the Indian entity engaged in r&d
activities, in case any of the condition mentioned in circular
3/2013 is not satisfied.
64 GE India Technology Centre (P.) Ltd. v. DDIT - [2013] 141 ITd
245 (bangalore). 65 Apex authority for Indian direct tax
administration.
Conceptual background from a Permanent Establishment perspective
(contd.)
navigating Key Tax Issues in India | 35
Current scheme of TP regulations for R&D centres The above
circulars were later withdrawn and replaced by circular 6 of 2013.
The latest circular states that r&d centres in India can be
classified into (a) entrepreneurial in nature, (b) cost-sharing
arrangements; and (c) contract r&d.
The new circular lays down following guidelines for determining
whether the Indian entity is engaged in contract r&d activities
and assumes insignificant risks.
a) Foreign AE performs most of the economically significant
functions like conceptualization, design, providing strategic
direction and framework, involved in research while the Indian
R&D Centre carries out the work assigned to it;
b) Foreign AE provide funds and significant assets required for the
research;
c) The R&D Centre works under the direct supervision of the
foreign AE;
d) The R&D Centre does not assume or has no economically
significant realized risks, both in substance and in form;
e) An AE located in low or no tax jurisdiction will be presumed to
be bearing no risks. The presumption can however be rebutted with
evidence.
f) The R&D Centre has no ownership right (legal or economic) on
the outcome of the research, both in substance and in form.
These guidelines are largely in line with the OEcd recommendations
as flow from revised discussion draft on Transfer Pricing Aspects
of Intangibles dated July 30, 2013.
TRAnSFER PRICIng AnD COnTRACT RESEARCh CEnTRES In InDIA
36 | Lakshmikumaran & Sridharan Attorneys
Experience of Indian administration has been that even those
entities who claim to have met these conditions fail to corroborate
their claims with sufficient documentary evidence. maintaining a
robust documentation is therefore crucial for sustainability of the
position adopted.
Managing the risk The change in the approach of tax administration
is definitely welcome. Further, the tax policy framework offers
options like (a) safe harbour rules and (b) advance pricing
agreements that can be used to reduce the risk of any divergent
view being taken by tax officers leading to unwanted
litigation.
A. SAFE hARbOuR
cbdT in September, 2013 announced the Safe harbour rules providing
that the transfer price declared by the taxpayer engaged in
rendering contract r&d services in the light of circular 6
above would be accepted if its operating profit / operating
expenses is not less than 29%66 / 30%67.
b. ADvAnCE PRICIng AgREEMEnT (APA)
The Indian APA scheme was introduced by the Finance Act 2012, with
effect from July 1, 2012. corresponding rules for effective
implementation were announced on August 30, 2013. The scheme has
been quite popular amongst the taxpayers. The scheme provides for
pre-filing consultation, a preliminary processing of the
application, across the table discussions, site visits by tax
officers, post APA compliance and reduced scope of audit by tax
officers. regime envisages unilateral, bilateral as well as
multilateral APAs. recently in Fiscal budget 2014 the scheme has
been further expanded to cover roll back upto four past years in
addition to five subsequent years.
66 For contract r&d services (wholly or partly) relating to
generic pharmaceutical drugs. 67 For contract r&d services
(wholly or partly) relating to software development.
Current scheme of TP regulations for R&D centres (contd.)
navigating Key Tax Issues in India | 37
COnCLuDIng REMARKS
Keeping pace with industrial development and business dynamics, the
role of R&D in profit generating process has been realised to
be significant enough to warrant profit attribution and deserving
ALP consideration in PE and subsidiary scenarios
respectively.
Considering the fact that determining the nature of R&D
activities is a fact based exercise and there can be subjectivity
in evaluating the functional profile of a captive R&D centre,
proper documentation should be maintained to demonstrate compliance
with conditions mentioned in Circular 6/2013.
Taxpayers should also consider opting for an APA which, with roll
back provisions can provide certainty for good nine years.
TRAnSFER PRICIng AnD COnTRACT RESEARCh CEnTRES In InDIA
notes...
lakshmikumaran & Sridharan is a full service law firm offering
services in Tax, International Trade, corporate and Intellectual
Property laws.
The firm has one of the largest law practices in India providing
litigation, consulting and advisory services to clients over the
last 29 years. We have handled more than 30,000 litigations at
various fora and advised clients on multitude of transactions. Our
clients include several Fortune 500 and reputed Indian
companies.
Should you have any query based on the contents of this booklet,
please get in touch with
v. lakshmikumaran at
[email protected] or S. Seetharaman at
[email protected] or Sumeet Khurana at
[email protected]
For more information, visit us at www.lakshmisri.com
Disclaimer: ‘Navigating Key Tax Issues in India’ is meant for
informational purpose only and does not purport to be advice or
opinion, legal or otherwise, whatsoever. The information provided
is not intended to create an attorney-client relationship and is
not for advertising or soliciting. lakshmikumaran & Sridharan
or its associates are not responsible for any error or omission in
this booklet or for any action taken based on its contents.
© 2014 lakshmikumaran & Sridharan. All rights reserved.
[email protected]
nEW dElhI 5 link road, Jangpura Extension, new delhi 110014 ---
b-6/10, Safdarjung Enclave new delhi - 110 029 Phone : +91-11-4129
9811 E-mail :
[email protected]
mumbAI 2nd Floor, cnErGy IT Park, Old Standard mill, Appa Saheb
marathe marg, Prabhadevi, mumbai - 400 025 Phone : +91-22-2439 2500
E-mail :
[email protected]
chEnnAI 2, Wallace Garden, 2nd Street chennai - 600 006 Phone :
+91-44-2833 4700 E-mail :
[email protected]
bEnGAluru World Trade center, no. 404-406, 4th Floor, South Wing,
brigade Gateway campus, no. 26/1 dr. rajkumar road, malleswaram
West, bengaluru - 560 055 Phone : +91-80-49331800 E-mail :
[email protected]
hydErAbAd ‘hastigiri’, 5-9-163, chapel road Opp. methodist church,
nampally hyderabad - 500 001 Phone : +91-40-2323 4924 E-mail :
[email protected]
AhmEdAbAd b-334, SAKAr-vII, nehru bridge corner, Ashram road,
Ahmedabad - 380 009 Phone : +91-79-4001 4500 E-mail :
[email protected]
EurOPE lakshmikumaran & Sridharan SArl Avenue Giuseppe-motta
35-37 1202 Geneva Phone: +41 22 919 04 30 Fax: +41 22 919 04 31
E-mail:
[email protected]
PunE 607-609, nucleus 1 church road, camp Pune - 411 001 Phone :
+91-20-66801900 E-mail :
[email protected]
KOlKATA 2nd Floor, Kanak building 41, chowringhee road Kolkata -
700071 Phone: +91-33-40055570 E-mail
:
[email protected]
chAndIGArh ScO no. 59, 1st Floor, Sector 26, madhya marg,
chandigarh – 160 026. Phone: +91-172-4921700 E-mail:
[email protected]
An ISO 9001:2008 and ISO 27001:2005 certified law firm